Thursday, October 13, 2016

Canada's Policy Dilemma

You may have seen on the Toronto / Vancouver Housing page that home prices in these two cities have increased rapidly. Home prices are likely fueled by a combination of very low interest rates, loose lending standards and greed/reflexivity.

As home prices (and household debt) reach stratospheric levels, it becomes clear that any interest rate increases would strain the entire system. The authorities now face an interesting dilemma. On the one hand, a weak economy and low commodity prices need support from lower interest rates. Meanwhile, prices for certain asset classes like residential real estate have increased steadily. (Or dramatically, in Vancouver and Toronto.)

To a certain degree, higher prices (due to low rates) make sense. The carrying cost of a large mortgage at low rates is similar to that of a small mortgage at high rates. There are two fears though. One is when rates increase. The second is whether the principal repayment is at risk as mortgages get ever-larger and incomes remain stagnant.

Recently, the government stepped in with a series of targeted measures to slow price increases. The new rules were largely aimed at closing tax loopholes on foreign buyers and increasing requirements for mortgage insurance. Pushing more risk from the government-owned mortgage insurer onto private lenders should improve lending standards.

There is a certain irony to these measures though. If they work as intended and residential real estate activity decline to normal levels, the Bank of Canada may have to cut rates further to juice the economy.

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